Private Equity: Barbarians at Middle Age

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In a study from 1989 entitled “The eclipse of the public corporation”, Michael Jensen argued that privately owned companies should perform better than their listed rivals. His paper provided the intellectual underpinning for private equity, which has since turned the business of managing unlisted companies into a $3 trillion industry. Despite this success, Mr Jensen’s arguments seem somewhat less apposite now that four of the leading private-equity houses—KKR, the Carlyle Group, Blackstone and Apollo Global Management—have themselves gone public.

Investors have decided that they can live with the irony: shares in the big listed private-equity firms are up by between 48% and 131% since May 2012, when Carlyle became the last of them to float. The valuations are partly a reflection of America’s bubbly stockmarket, up by 33% in the same period. In much the same way that an energy company’s shares rise in tandem with oil prices, private-equity firms are boosted when stockmarkets are high, as the value of the companies they own rises. (Although they hold their stakes on behalf of investors, they keep a share of the gains.)

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Having shareholders is not the only thing that has changed for the firms that pioneered private equity. They have become bigger, accumulating assets under management at a furious clip (see chart at left). They are also becoming duller. Whereas KKR and its peers were once at the forefront of finance’s most exciting deals, borrowing vast amounts to seize control of underperforming companies in hard-fought takeover battles, they often now merely extend loans to such businesses. Investing in infrastructure, once perceived as a backwater, is also popular. By contrast the leveraged buy-out, the mainstay of private equity, is turning into a marginal activity. Of the $266 billion managed by Blackstone, only $66 billion is in private equity.

The firms say they have diversified into different product lines just as any other business would. Some doubt whether traditional buy-outs offer the best risk-adjusted returns. The industry has matured: fat profits in past decades have attracted over 5,000 rivals competing for the same deals. Together they have raised more money from investors than they know what to do with. Many buy-out firms have resorted to buying and selling stuff to each other. And prices for companies (as multiples of profits) are higher than even at the height of the credit boom. Eking out gains is hard when paying over ten times a firm’s earnings, as is now typical, compared with less than eight times in calmer periods.

By contrast, lending to companies is a much less crowded field now that banks are busy repairing their balance-sheets. It is less sexy than buy-outs, but it holds another attraction: though fees tend to be lower, they are relatively skewed towards the annual levy of 1-2%, known as management fees, which private-equity firms charge regardless of how their investments fare. These used to be a mere bonus: private-equity firms once earned most of their income from a 20% cut of investors’ profits, known as “carried interest”. Yet when analysts value “alternative investment” firms, they typically attach three times more value to the reliable income from management fees than to erratic carried interest. Bosses fretting about their share prices will therefore chase humdrum volume over dramatic but risky deals.

This shift is not so good for institutional clients, such as pension funds, which are happy enough to split profits but loathe management fees. Promised annual returns have inched down from the 20-30% range to perhaps half that. That is still better than anything you can do legally with your money, points out David Rubinstein, one of Carlyle’s bosses. But the ever-more-assets route stands in contrast to large hedge funds, which have capped the amount of money they manage to preserve their investors’ returns.

There are other reasons why private equity’s titans have become more staid. The nine founders of the four big firms, who between them earned $2.5 billion last year, are nearing retirement age. Their successors are administrators rather than daredevils. “These guys aren’t playing to win, they are playing not to lose,” as one industry figure puts it. Achieving outsized returns is hard with a $18.4 billion fund—the size of Apollo’s latest buy-out war chest—compared with the mere hundreds of millions of yesteryear.

The outlook for the listed firms is mixed. On the one hand, investors are desperate for higher yields, and “alternatives” offer good returns. Investors are also flush with money, given recent stockmarket gains. And they are not immune to the charms of a one-stop shop: a big American university endowment being wooed to invest in European private equity, say, can be sold an Asian property fund at the same time. Better yet, regulatory changes make it easier for Carlyle and others to pursue retail investors, potentially further swelling their assets under management.

On the other hand, many of private equity’s customers have been driven to it by low interest rates, which will not last forever. Stockmarkets are also unlikely to remain so frothy. Leon Black, Apollo’s boss, has quipped for over a year that he is “selling everything that isn’t nailed down”. The last time the cycle turned, in 2008, Blackstone’s shares fell to just 13% of their 2007 listing price. Fees are coming under pressure, partly because big investors such as sovereign-wealth funds are trying to do their own buy-out deals. And long-discussed reforms to the tax code in America could hurt some bits of their business.

Like a middle-aged man clinging to youth, the buy-out firms want to preserve the vestiges of their past. All fret about losing the culture that made them successful as they go from dozens of staff to hundreds, if not thousands. Employees are their largest shareholders, but that will inevitably change. For now, Byzantine corporate governance means managers are all-powerful. But a time will come, perhaps, for some swashbuckling corporate raiders to shake them from their torpor.